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When Is Income Recognized Under Cost-Plus Contracts?

By Cathy Fitzpatrick, CPA, MST, Washington, DC

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Tax Section

Editor: Mary Van Leuven, J.D., LL.M.

Generally, tax law delays recognition of income until the
all-events test is satisfied. The IRS recently issued
taxpayer-favorable guidance, ruling that an accrual-method
taxpayer recognizes income from the reimbursement of
allowable costs under cost-plus contracts when the amounts
are billed and due, not when the taxpayer incurs the
reimbursable costs. This item recaps the IRS guidance and
considers what it may mean for other taxpayers.

On
January 18, 2008, the IRS released Technical Advice
Memorandum (TAM) 200803017. The TAM addresses the treatment
of income earned by an accrual-method taxpayer for services
it provided to the U.S. government under cost-plus
contracts. The taxpayer was a contractor that performed
technical services, including research and design,
information technology, engineering and consulting,
training, and operational services for the U.S. government.
Under cost-plus contracts, the government reimburses a
contractor for its costs and separately negotiates and pays
the contractor a profit for work related to the
contracts.

The Federal Acquisition Regulations (FAR)
generally provide the rules for government cost-plus
contracts. The FAR provide the terms for each contract,
including timing payments and bills and establishing a
ceiling for total costs incurred by the contractor
(allowable costs). In the case of cost-plus contracts for
services, a contractor may submit interim bills for
allowable costs incurred, subject to the government’s right
to inspect and test all contract services. If the services
do not conform to the contract requirements, the government
may require the contractor to repeat the services for no
additional fee. When the contractor cannot correct the
defects by reperformance or fails to promptly reperform the
services, the government has additional remedies available,
such as reducing the fee payable or terminating the contract
for default. Finally, in some cases, the government may
terminate a cost-plus contract for convenience. This usually
occurs when the government believes that the project is no
longer viable or that the funds should be spent on other
projects. If a contract is terminated for convenience, the
contractor may be reimbursed for its allowable costs and
paid an appropriate percentage of its contract fee.

Timing of Income Recognition

At issue in the TAM
was whether the taxpayer was required to recognize service
income for reimbursable allowable costs when it incurred the
costs or when the amounts were due (billable). Under the
accrual method of accounting, under Sec. 451 and Regs. Sec.
1.451-1(a), income is includible in gross income when all
the events have occurred that fix the right to receive the
income and the amount of income can be determined with
reasonable accuracy (the all-events test).

As
interpreted by the courts and the IRS, in the absence of a
contingency affecting the taxpayer’s right to income, the
all-events test is satisfied on the earliest of when either
(1) the income is received, (2) the income is due, or (3)
the required performance or events have occurred. See, e.g.,
Schlude, 372 US 128 (1963); Rev. Rul. 2004-52; Rev.
Rul. 2003-10; and Rev. Rul. 84-31. The Tax Court held in
Decision, Inc., 47 TC 58 (1966), acq.
1967-2 CB 2, that the terms of an agreement can be relevant
in determining when the all-events test is met.

During an examination of the taxpayer, the IRS’s
examining agent concluded that the taxpayer should have
recognized income as reimbursable allowable costs were
incurred, even though not yet billed or received. The agent
argued that the all-events test was satisfied and the
required performance occurred as the taxpayer incurred costs
in performing under its cost-plus contracts because the
taxpayer would, in all circumstances under the contracts’
terms, receive income representing the amount of the costs.
Disagreeing with the agent’s conclusion, the IRS National
Office determined in the TAM that the taxpayer did not have
to recognize income for the costs until the amounts were
due.

The National Office found that the taxpayer’s
cost-plus contracts were similar to the service agreements
in the 1966 Decision case. The defendant in
Decision derived income from the sale of
advertising space in a job directory. Advertisers who
purchased space in the directory signed a contract that
allowed the advertisers to immediately use the defendant’s
résumé service. Directory advertising orders were due by
November 1963, invoices were sent in January 1964, and the
directory was published the next month. In holding that the
defendant did not have a fixed right to receive income until
the billing date, the Tax Court rejected the IRS’s argument
that the defendant’s right to receive income was fixed by
performance of a portion of the services required under the
contract (the résumé services). In so concluding, the court
stated that the IRS “has referred us to no cases holding
that income accrues upon part performance of a contract
prior to an agreed billing or payment date.”

Based on
the factual similarities of the taxpayer’s situation to that
in Decision, the National Office commented that the
examining agent’s position depended on the cost portion of
the cost-plus contract being divisible from the rest of the
contract and cited Rev. Rul. 79-195. In that ruling, the IRS
concluded that a divisible portion of service income was
earned before all contract services were completed. The
ruling involved a correspondence school that received
federally guaranteed promissory notes as payment for home
study courses. Each course consisted of several lessons to
be completed by a student over a 36-month period. The
tuition contracts and promissory notes conditioned payment
on the school’s rendering of the instruction and the
student’s completion, on a lesson-by-lesson basis, of the
courses. No amounts were due or paid until nine months after
the student graduated or ceased to carry a certain academic
workload. The ruling concluded that the school recognized
tuition income when a student completed each lesson.

The National Office distinguished the taxpayer’s
cost-plus service income from the tuition income in Rev.
Rul. 79-195 and noted that in the ruling, the income accrued
represented all income attributable to the portion of the
services completed during the tax year of the accrual. To
the contrary, performance under the cost-plus contracts
entitled the taxpayer to both cost reimbursement income and
possible fee income attributable to the same performance.
Therefore, by contending that only the cost reimbursement
income is includible in gross income, the examining agent
attempted to divide the required performance under a
contract based on divisible components of the amounts to be
billed under the contract, as opposed to dividing the
required performance into divisible services. The National
Office stated,

We are not aware of any
authorities that permit divisibility based on components
of the billable amounts for federal income tax purposes.
Consequently, we do not think the required performance for
the accrual of the cost portion of the billable amount
differs from the required performance for the fee portion
of the billable amount. For both amounts, the required
performance has not occurred prior to the time the amounts
under the contract are due.

Therefore, according to the National Office, the taxpayer
does not have a fixed right to receive income under the
cost-plus contracts until the amounts become due.

Practical Implications

Although in TAM 200803017
the National Office specifically addressed income earned for
the provision of research, information technology,
engineering, consulting, and similar services under a
cost-plus contract, its analysis may be applicable to a
service provider that enters into contracts with customers
under which billing and payment are deferred and the
required services are not divisible into separate
components, even where fees are not determined on a
cost-plus basis. Based on the TAM, a taxpayer who has these
types of contracts and is reporting income as the services
are partially performed, rather than when the services are
complete, may be able to start deferring the income until
the date of completion or the date of billing or collection,
if earlier. (However, it should be noted that a holding in a
TAM applies only to the taxpayer for whom the advice was
requested.)

A taxpayer’s timing of recognizing income
from services is an accounting method within the meaning of
Sec. 446. Thus, any change in the treatment of such income
by a taxpayer is a change in the method of accounting within
the meaning of Sec. 446(e), which requires the taxpayer to
secure the IRS’s consent before implementing such a change.
A method change from recognizing income as services are
partially performed (but when the income is not yet
received, due, or earned) to recognizing income when
services are complete is subject to the nonautomatic
provisions of Rev. Proc. 97-27 (as modified by Rev. Proc.
2002-19). Therefore, taxpayers who, after consultation with
their tax advisers, wish to request this change must file
Form 3115, Application for Change in Accounting Method, by
the last day of the year of change.

EditorNotes

The information contained in this Tax Clinic is general
in nature and based on authorities that are subject to
change. Applicability to specific situations is to be
determined through consultation with your tax adviser. The
views and opinions expressed are those of the authors and
do not necessarily represent the views and opinions of
KPMG LLP.

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